Unit 9 Lenders and borrowers and differences in wealth

9.5 Application: Discounting, external effects, and the future of the planet

Discount rates are central to the discussion in economics of how best to address climate change and other environmental damages. But what is discounted is not the value placed by a citizen on their consumption later (as opposed to consumption now) but instead the value we place on the consumption of people living in the future compared to our own generation.

Our economic activity today will affect how climate changes in the distant future, so we are creating consequences that others will bear. This is an extreme form of external effects that we study throughout the book. It is extreme not only in its potential con­sequences, but also in that those who will suffer the consequences are future genera­tions. But the future generations that will bear the consequences of our decisions are unrepresented in the policymaking process today. The only way the wellbeing of these unrepresented generations will be taken into account at the environmental bargaining tables is the fact that most people care about, and would like to behave ethically toward, others, as we discussed in Unit 4.

These social preferences underlie the debates among economists about how much we should value the future benefits and costs of the climate change decisions that we make today.

In the model developed in this unit, we know that the actor (say, Julia) is best off when she chooses the combination of consumption now and later where the MRS = MRT; that is, where her subjective discount rate is equal to the rate of interest.

In considering alternative environmental policies addressed to climate change, how much we value the wellbeing of future generations is commonly measured by an interest rate; that is, by applying the same MRS = MRT approach. This raises the question of what interest rate should be used to discount future generations’ costs or benefits. Economists disagree about how this discounting process should be done.

When economists disagree The discounting dilemma: How should we account for future costs and benefits?

When considering policies, economists seek to compare the benefits and costs of alternative approaches, often in cases where some people bear the costs and others enjoy the benefits. Doing this presents especially great challenges when the policy problem is climate change. The reason is that costs will be borne by the present generation but most of the benefits of a successful policy to limit CO2 emissions, for example, will be enjoyed by people in the future, many of whom are not yet alive.

Put yourself in the shoes of an impartial policymaker and ask yourself: Are there any reasons why, in summing up the benefits and costs of such a policy, I should value the benefits expected to be received by future generations any less than the benefits and costs that will be borne by people today? Two reasons come to mind:

  • Technological progress and diminishing marginal utility: People in the future may have lesser unmet needs than we do today. For example, as a result of continuing improvements in technology, they may be richer (either in goods or free time) than we are today, so it might seem fair that we should not value the benefits they will receive from our policies as highly as we value the costs that we will bear as a result.
  • Extinction of the human species: There is a small possibility that future generations will not exist because humanity becomes extinct.

These are good reasons why we might discount the benefits received by future generations. Neither of these reasons for discounting is related to intrinsic impatience.

This was the approach adopted in the 2006 Stern Review on the Economics of Climate Change (read the executive summary on the UK National Archives website). Nicholas Stern, an economist, selected a discount rate to take account of the likelihood that people in the future would be richer. Based on an estimate of future productivity increases, Stern discounted the benefits to future generations by 1.3% per annum. To this he added a 0.1% per annum discount rate to account for the risk that in any future year there might no longer be surviving generations. Based on this assessment, Stern advocated an urgent and fundamental shift in the policies of governments and businesses to ensure substantial investments to limit CO2 emissions today in order to protect the environment of the future.

Several economists, including William Nordhaus, criticized the Stern Review for its low discount rate. Nordhaus wrote that Stern’s choice of discount rate ‘magnifies impacts in the distant future’. He concluded that, with a higher discount rate, ‘the Review’s dramatic results [Stern’s policy conclusions above] disappear’.1

Nordhaus advocated the use of a discount rate of 4.3%, which gave vastly different implications. Discounting at this rate means that a $100 benefit occurring 100 years from now is worth only $1.48 today, while under Stern’s 1.4% rate it would be worth $24.90. This means a policymaker using Nordhaus’s discount rate would approve of a project that would save future generations $100 in environmental damages only if it cost less than $1.48 today. A policymaker using Stern’s 1.4% would approve the project only if it cost less than $24.90.

Not surprisingly, then, Nordhaus’s recommendations for climate change abatement were far less extensive and less costly than those that Stern proposed. For example, Nordhaus proposed a carbon price of $35 per ton in 2015 to deter the use of fossil fuels, whereas Stern recommended a price of $360.

Why did the two economists differ so much? They agreed on the need to discount for the likelihood that future generations would be better off. But Nordhaus had an additional reason to discount future benefits: intrinsic impatience.

Reasoning as we did in Julia’s choice of consumption now or later, Nordhaus used estimates based on market interest rates (the slope of the feasible set) as measures of how people today value their own future versus present consumption. Using this method, he came up with a discount rate of 3% to measure the way people discount future benefits and costs that they themselves may experience. Nordhaus included this in his discount rate, which is why Nordhaus’s discount rate (4.3%) is so much higher than Stern’s (1.4%).

Critics of Nordhaus pointed out that a psychological fact like our own impatience—how much more we value our own consumption now versus later—is not a reason to discount the needs and aspirations of other people in future generations.

Stern’s approach counts all generations as equally worthy of our concern for their wellbeing. Nordhaus, in contrast, takes the current generation’s point of view and counts future generations as less worthy of our concern than the current generation, much in the way that, for reasons of intrinsic impatience, we typically value current consumption more highly than our own future consumption.

Is the debate resolved? The discounting question ultimately requires adjudicating between the competing claims of different individuals at different points of time. This involves questions of ethics on which economists will continue to disagree.2

Exercise 9.4 Simulating different discount rates

Download the simple discount rate simulation spreadsheet from our CORE Econ website. The simulator allows you to calculate the present value of receiving $1 in 1, 10, 50, and 100 years from now for four discount rates.

In the spreadsheet, the first three discount rates are fixed: zero, Stern’s suggestion, and the alternative suggested by Nordhaus.

  1. Explain the effect of different discount rates on the present value of receiving $1 in the future.

The fourth rate is your choice: use the slider in the table to choose a discount rate you think is appropriate for the evaluation of the benefits and costs of climate change policy in the distant future.

  1. Justify your choice. (Is it closer to the Nordhaus or Stern proposal, or is it higher than or lower than both, and why?)
  2. Try to find out what discount rate your government (or another government of your choice) uses to evaluate public investment projects. Explain whether or not you think this discount rate is appropriate.

Exercise 9.5 Negative discount rates

Some economists have suggested that the discount rate for future environmental benefits and costs should be negative, meaning that we value benefits and costs experienced by future generations more than those experienced by the current generation.

Use your diagram and the arguments presented in the following articles to explain why this suggestion might make sense:

Question 9.7 Choose the correct answer(s)

The following table shows the present values of a $1 payment in the future, discounted at different rates. For example, $1 paid in 10 years’ time is worth $0.82 today when discounted at 2% annually.

Discount rate (%) Years in the future
0 1 10 50 100
0.0% $1.00 $1.00 $1.00 $1.00 $1.00
1.0% $1.00 $0.99 $0.90 $0.61 $0.37
2.0% $1.00 $0.98 $0.82 $0.37 $0.14
5.0% $1.00 $0.95 $0.61 $0.09 $0.01

Based on this information, read the following statements and choose the correct option(s).

  • The difference in the discounting effect among alternative discount rates is larger as the time to payment increases.
  • Doubling the time to payment leads to halving of the present value.
  • Doubling the discount rate leads to halving of the present value.
  • If a project is expected to give benefits of $1,000 10 years from now, but costs $800 today, policymakers using any discount rate shown in the table above would recommend approving the project.
  • Across the full range of discount rates presented, present values remain quite similar when payment is due in 1 year’s time—for instance, the gap between the present value at 1% and 5% discounting is only $0.04. When the payment is in 50 years, by contrast, the gap between present value at 1% and 5% discounting has grown to $0.24.
  • For instance, at a 5% discount rate, the present value of a $1 payment due in 5 years is $1 × (0.95)5 = $0.77. The present value of a $1 payment due in 10 years is $1 × (0.95)10 = $0.60.
  • For instance, at a 1% discount rate, the present value of a $1 payment due in 10 years is $1 × (0.99)10 = $0.90. At a 2% discount rate, the present value is $1 × (0.98)10 = $0.82.
  • Policymakers using a 5.0% discount rate would not approve of the project because the benefits 10 years from now ($610 today) are less than the costs today ($800).
  1. William D. Nordhaus. 2007. ‘A Review of the Stern Review on the Economics of Climate Change.’ Journal of Economic Literature 45 (3): pp. 686–702. 

  2. Frank Ackerman. 2007. ‘Debating climate economics: the Stern Review vs. its critics’. Report to Friends of the Earth, July 2007.